**1. Introduction**

The aftermath of the 2007 global financial crisis led to the tightening of corporate governance practices among financial institutions. As the apex of the internal governance system, board of directors have a duty in ensuring adherence and compliance with sound banking practices. The internal control framework of the Basel Committee on Banking Supervision (BCBS) reiterates the role of board of directors and senior management in ensuring that there is efficiency, compliance and standard reporting of banking activities. Prior to the 2007 global financial crisis, the BCBS had reported the importance of bank internal controls. The breakdown of internal control systems is attributable to weak management oversight, accountability and control culture, inadequate risk assessment of banking activities, failure

of control structures and activities, ineffective share and flow of internal information and ineffective internal audit and monitoring activities [1].

chapter to the agency theory is how board chair being ex-CEO increases bank risks. Prior research [10–12] uses CEO duality which is defined as situations where existing CEOs double as board chair. Our study uses current chair being ex-CEO to determine the effect of previous position (ex-CEO) in influencing board functions. We find that board chair being ex-CEO increases bank credit risk which is contrary to the views of John et al. [12] that CEO duality increases corporate governance. One other strength of this chapter is its complementarity to existing and widely used quantitative approaches to managing credit risk. The chapter encourages the use of internal governance mechanisms to address a major problem in banking. The rest of the sections cover hypotheses development, methodology, results and dis-

*Internal Controls and Credit Risk in European Banking: The Basel Committee on Banking…*

**1.1 Basel Committee of Banking Supervision framework for internal control**

and segregation of duties, information and communication and monitoring

• Senior management has a duty to ensure the implementation of board

• The role of board of directors includes reviewing policies, have understanding and ability to manage risks and ensure that senior management complies. The board has a duty to ensure the establishment and maintenance of internal

developed policies, develop processes for identifying, measuring, monitoring and controlling risks and internal control systems through delegation and

• Board of directors and senior management must exemplify a culture of ethical behavior and integrity and respect for internal controls by full engagement

• Regular, effective and continuous assessment of all material risk exposures of

• Appropriate control structure at all business levels, ensuring enforcement of compliance and approval limits, reconciliation and verification systems,

**1.2 Thirteen principles of the BCBS internal control framework**

Following significant losses in banking organizations, the concerns to minimize such occurrences triggered the coming together of experts from various countries to develop a framework that will guide the conduct of banking business. The motivation behind the development of the framework for internal control systems is to address and enhance supervisory issues that encourage sound risk management practices [1]. The confidence in an effective and functioning control system is its ability to prevent and enable earlier detection of catastrophic but avoidable potential losses. Thus the framework is meant for member countries worldwide to use in evaluating internal control systems among banks albeit the situational circumstances pertaining to different countries. The Basel Committee on Banking Supervision which is a subcommittee of the risk management committee of the Bank for International Settlements outline 13 principles for assessing internal control systems captioned under five main areas or elements. The broad areas include management oversight and the control culture, risk recognition and assessment, control activities

cussion, and conclusion.

*DOI: http://dx.doi.org/10.5772/intechopen.92889*

**systems**

activities.

control systems.

segregation of duties.

the bank

**19**

physical controls

Some researchers argue that poor risk management practices and weak corporate governance systems partially or significantly account for the 2007 global financial crisis [2, 3]. The crisis led to high rates of non-performing loans which affected several economies in the US and Europe. In a briefing to the European Parliament, the authors lament the rate of non-performing loans leading to credit risk among EU countries during and after the global financial crisis [4]. Prior research identifies factors such as low profitability, bank size and high concentration of banks in lending as key determinants of credit risk in the banking industry [5]. This study explores qualitative self-regulation approach using the BCBS internal control framework to investigate how internal controls affect credit risk in European banking. This chapter extends prior research about the banking industry in Spain where the authors find significant relation between the elements of internal controls using the COSO framework [6]. The study differs from existing ones in several ways. Whilst previous study focuses on a single country, the current chapter covers several countries within the EU thus making it broader and wider. The work of Akwaa-Sekyi and Moreno [6] uses single variables to measure the elements of internal controls but the current study uses several variables which cover the principles of internal controls. Unlike the previous study which uses the COSO framework, this chapter uses bank-related framework suggested by the BCBS. To the best of our knowledge, this is the first chapter to use the BCBS internal control framework to study its relationship with credit risk within the European banking.

This chapter derives motivations from three sources. The first motivation for this study comes from Cho and Chung [7]. They find that banks with weak internal control weakness report high provision for loan losses and loan loss reserves which exacerbates credit risk. Anytime banks intensify efforts to strengthen internal control weaknesses, there were reductions in provisions and loan loss reserves [7]. Based on their findings, we propose the use of the BCBS internal control framework to minimize bank credit risk. Second, prior research by Uhde et al. [8] motivates this chapter. In reviewing existing literature Uhde et al. [8] underscore the relevance of a framework that combines board structure and composition to ensure effective board monitoring. We concur with this integrated framework approach and therefore propose the joint effect of board functions and activities, board structure and board monitoring to minimize bank credit risk. Finally, the work of Karkowska and Acedański [9] motivates this chapter. The authors conclude that there is no much change in the corporate governance and bank stability nexus after the financial crisis and therefore suggest the need to strengthen corporate governance practices. This implies there is still room for banks to improve upon their corporate governance practices to deepen and sustain investor confidence in the banking system. For this reason, we suggest an internal control framework that is quite exhaustive in addressing the menace of investor losses such as credit risk. Failures to detect breakdowns in internal controls lead to massive fraud which puts shareholder investment in jeopardy and lack of confidence in the banking sector. The chapter seeks to fill these research gaps by analyzing how internal governance of the BCBS framework of internal controls affects credit risk.

The contributions of this chapter are not far-fetched. First, this chapter extends the literature on the relationship between board functions and activities and bank credit risk. The findings suggest that effective board functions and activities minimize bank credit risk. Second, this study proffers evidence to support the agency and institutional theories to monitor managerial behavior likely to result in investment losses through credit risk. The result complements existing research that independent board structure minimizes credit risk. Another contribution of this
